Why Dump The Hedgers?

July 2, 2003

Because!

I know, I know. That doesn’t say a whole lot. So, let’s go through it step by step:

What does a hedging gold producer do? He sells gold he expects to produce in the future, gold that is still in the ground, now, so that he can lock in an advantageous (he thinks) price per ounce because he is afraid that by the time he gets the gold out of the ground, the price will be lower.

So he contacts his friendly bullion banker, which of course isn’t stupid and won’t lend the producer any of his bank’s own money. Instead, because he has such great connections in the banking world, the bullion banker "just happens to know" a central bank that wants to get rid of its "worthless" gold for a measly, sub-one percent "lease rate."

The central bank proceeds to "lease" that gold to the bullion bank, which goes on to sell it in the market and gives the proceeds to the producer. The producer, on the other hand, contracts with the bullion banker to give his next (or whatever) future batch of gold produced to the bullion banker in return for the money the bullion bank "advanced" to the producer.

(Side note: Do you think there is an institutional bias for bullion banks to encourage forward selling by producers? BBs get to "loan" out something that doesn’t belong to them in return for a promise to receive future gold production, pay only one percent or less for that deal, plus they contract with the producer to receive a certain amount of physical gold above and beyond what the BBs must to return to the central bank as their "commission." Sweet deal? You bet!)

Anyway, the end result is that the producer’s future production no longer belongs to him. It belongs to the bullion bank that advanced him the money.

As you well know, that’s all fine and good as long as the gold price environment favors countinuously low or falling prices. But when that environment changes, so does the profit outlook for producers.

This has become very evident during the recent gold bull run from March 2001 to February of 2003. Giant hedgers like Barrick didn’t fare well at all, while unhedged producers’ stocks went halfway to the moon.

But that is not the only danger. The problem is not just that hedgers can’t enjoy a gold price hike as much as unhedged prducers can and therefore lack some profit potential.

The real problem lies in what will happen when physical gold scarcity freezes up the paper-gold markets, i.e., when there isn’t enough physical gold available at current (still extremely low) prices to satisfy even those few counterparties who insist on physical delivery without rollovers, etc.

When that happens, the price of physical gold will predictably shoot to somewhere around Mars. Let’s just say, it will go to ... uhm, say $600 per ounce?

At that time the paper market will still "say" that gold "costs" maybe $380/oz, or so, but physical gold will actually trade (outside the paper markets) for multiples of that alleged "price."

Now our poor hedging producer will have to go through all that trouble of getting the metal out of the ground and processing it into usable form, but he has to literally give it away to the bullion bank that loaned him that last couple-million bucks for his production. He already got his money in the past, so its: "bye, bye, beautiful gold!"

If he could have sold the physical gold to the consumer directly, or maybe at least to the bullion dealer, he could have made some serious cash, but now he is stuck. Either he gives it away to the bullion banker, or he sells it at market and offers some kind of cash settlement somewhere between forward price and current spot to the BB.

But the BB has another iron in the fire (and a monkey on its back): The "monkey" is the central bank that wants its gold back, and the iron in the fire is its contractual right to force the producer to cough up the gold, or the ability to legally force him into receivership or bankruptcy for defaulting on the foward contract

In such a circumstance, where do you think the share price of the producer is now going? That’s right: on an extended vacation to the Deep South. And who holds those shares? You do! And what happens to your portfolio? It suddenly feels way to frigid up north, and wants to take a "vacation," too ...

That is the real danger of holding shares of a hedged gold producer. Total collapse, not just a percentage "loss." You can lose your entire investment. Think Enron!

Now, the question is: do you believe that gold can go to $600 an ounce anytime soon?

Sure you do.

Why else would you have invested in gold shares, hmm? If you say you don’t believe that, you have wasted your money already.

But does it really matter what you believe? Nope. Gold will go to $600 an ounce - at minimum - whether or not your believe that. Gold doesn’t care about your personal creed, it just responds to market forces (when it is allowed to, that is; and it becomes more and more clear that the forces who don’t want to allow it to rise have run out of gun powder. The US is now using the military option as a last-ditch effort)

And what are the market forces, currently? As noted in a recent article published here, entitled "Gold Will Rise - And Stay There!" the US has lost its vital "partner" in its war against rising gold prices: the twelve Euro member banks. The Euro CBs have set themselves up to benefit from a rising gold price, which is why they hammered out the Washington Agreement, thereby signalling their intentions to the rest of the world.

Will Russia, Turkey, India, or China (or the US government) come to the hedged producers’ aid when the paper markets incinerate and the physical gold price goes into orbit? Yeah, sure. (Hey, Psst! I have this great piece of real estate in the Florida Everglades to sell you - in case you’re interested.)

So, what are you going to do with your hedger’s shares now?

Alex Wallenwein
Editor, Publisher
The EURO vs DOLLAR CURRENCY WAR MONITOR
http://www.a1-guide-to-gold-investments.com/euro-vs-dollar.html
Moneypulation Watch (Free Ezine)

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